Giving a Market Room to Breathe

Welcome to this month’s Safety in the Market newsletter. The Euro Bund has made a nice double top on the September contract and has fallen around 400 points from its 23 July high. This is shown in Chart 1 below. (Note that I am using FGBL-2012.U, the September, 2012 contract, as opposed to the continuous chart, FGBL-Spotv.)

Chart 1

click chart to enlarge

Students who have studied David Bowden’s Price Forecasting lessons from the Number One Trading Plan might have had clear reasons for getting short in this market on the day of the top, perhaps using a ‘short the closers’ entry at the end of the day. For those who missed out, W.D. Gann said that the safest place to sell is the first lower swing top, which is marked in Chart 1 above.

The first lower swing top trade entry was confirmed on 1 August, 2012 with an entry just outside the 33% limit. The next day, 2 August, a speech by ECB President Mario Draghi spooked the markets, causing the Euro to plummet and the Euro Bund to soar. The move up lasted only half a trading day but it was enough to take out any stop losses that were placed one point above the first lower swing top.

This is what I would call an acceptable loss, that is the big picture trade setup was good (double top), the entry was good (first lower swing top) and the stop loss kept you from further losses. In my book, this is enough to tick the ‘excellent’ box in your Trading Plan when it comes to rating your performance.

I managed to get short the Euro Bund on the day of the second top (23 July, 2012). For students of history, the 23 July top was almost exactly the same price range and pattern as the November, 2011 and January, 2012 tops. I had my stop loss above the top of 23 July and left it there even after the first lower swing top was formed.

The exact top or bottom of a market is not the place I want to load up on contracts. The first position I take is generally the most I am risking on the trade and further positions will only be taken when I am risking the market’s money after the trade has gone my way.

Once I believe that the top of a market is in, I like to leave my stop loss above the actual top and give the market ‘room to breathe’. David Bowden said you need about two weeks to let the market prove whether it is at a top or not.

Some of the best lessons I have learned came from trading out of the 2007 and 2008 yearly tops on the US Dollar/Japanese Yen (FXUSJY in ProfitSource). For both of these, my initial goal was simple: I believed they were major tops so all I wanted to do was get short and hang on as long as I could.

In 2007, the US Dollar/Yen did almost the exact same thing the Euro Bund has done in the current market. It gave a first lower swing top entry, false broke it and then continued down, as is illustrated in Chart 2 below:

Chart 2

click chart to enlarge

While it didn’t stop me out in 2007, I realised in hindsight that giving the market room to breathe was a key factor in being able to take a sizable chunk out of the big move.

The June 2007 trade on the US Dollar/Yen was my first attempt at shorting a yearly top based only on my own analysis, which is one of the reasons my strategy was very cautious. By giving the market room to breathe, I was able to hold on when I might have been stopped out, I had time to watch the market unfold (and learn a few important things, like the size of the First Range Out) and most importantly, achieve a very good Reward to Risk Ratio on my trade.

Many traders come undone by trying to take too many positions too quickly in the market, only to be stopped out because they had a tight stop loss. David Bowden said: “we must learn to hasten slowly in the market”. As I said earlier, the exact top is not the place I want to be taking the most positions.

Once the market has unfolded for a few weeks, you will be in a better position to take your next trade. You will see what the market is doing and you will have profits on the table so that you are risking the market’s money rather than your own.

As an exercise, you may wish to look back at the 2007 and 2008 tops on the US Dollar/Yen. How could you have entered? How could you have stayed short? At what point could you have taken an additional, larger position with the market’s money?

I will be dissecting these moves at my Currency Forecasting Seminar on 22 September 2012. For full details, click here to see a short video summary.

During the online seminar, I will be explaining how I traded those moves, what I learnt from them and the best places to take a big position during a move. The lessons I learnt from these two tops provided much of the foundation for how I trade today and are well worth studying.

For now, I will be watching the Euro Bund closely. The first important price milestone is 133.76, being the 200% milestone of the double tops on the September contract (FGBL-2012.U), as shown in Chart 3 below:

Chart 3

click chart to enlarge

If the 1 June 1 and 23 July double tops prove to be the end of the bull market in the Euro Bund, then I believe 133.76 will only be a ‘pit stop’ on the long road down. If 133.76 provides a low and gives us a ‘First Range Out’, that range will be 1,250 points (146.26-133.76 = 12.50 or 1,250 points). The First Range Out from the 2007 top on the US Dollar/Yen was 1,254 points.

Time, as always, will tell! As long as the Bund stays below 143.13, the 50% milestone of the double tops shown above, I am confident the tops will hold.